Capital markets: Hello equities, goodbye bonds!

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The so-called great rotation from bonds to equities is already under way, but such a shift will be neither rapid nor particularly smooth.

Some $35 billion flowed back into equity funds in January ($19 billion of which was via long-only investment), according to Bank of America Merrill Lynch, signalling greater faith in equities than there has been for some time.

During the past seven years, investors poured a whopping $800 billion into bond funds, while redeeming $600 billion from equity funds.

However, if the great rotation is well and truly on, BAML investment strategists warn that there are two big risks to an orderly shift: a bond crash, as in 1994, or a risk shock as in 1987, driven by a currency war.

On the first, the strategists argue that if the global economy and corporate animal spirits revive sufficiently to cause a surprise lift to US payroll numbers in the coming months, say numbers in excess of 300,000 then a repeat of the 1994 bond shock is likely.

Back then, the combination of stronger-than-expected payroll, rate tightening by the US Federal Reserve, and a 200 basis point back-up in bond yields led to a big pause in the nascent equity bull market and a savage reversal of fortune in leveraged areas of the fixed-income markets.

Such a reversal caused havoc, not least the bankruptcy of California’s Orange County, the tequila crisis that engulfed Mexico and a close call for Goldman Sachs.

On the second, rising risk appetites in 1987 caused equity prices to drag bond yields higher. At the same time, policy tensions over currency valuations between Germany and the US also put upward pressure on bond yields, as well as gold prices.

Ultimately the combination of policy risks, rising gold and bond yields helped precipitate the October 1987 crash in equity markets.

Although the strategists argue that a repeat of 1987 is a low-probability event in 2013, they do say it is clear that risk appetite is on the rise – the S&P500 index traded above 1,500 late last month for the first time since December 2007 – many countries are trying to devalue their way to growth, risking a currency war, and should gold start to respond favourably to this backdrop, "we would certainly worry that a major risk correction is imminent".

One possible near-term catalyst or trigger for this, the strategists argue, could be the return of a leveraged-buyout boom, which, they say, would be a good fundamental reason for a re-rating of stock markets.

The environment is ripe for a pick-up in LBO deal-flow – global demand for yield has driven debt costs to super-lows, the cost of capital for buyout firms has fallen to some of the lowest levels in history and banks can once again provide financing – with computer maker Dell the latest target of speculation.

In the absence of an LBO boom, however, the strategists argue that there are plenty of other potential catalysts that could heighten the risk of a pullback in the spring, not least WTI oil prices, which quietly appreciated by $10 a barrel in January.

Suffice to say, caveat emptor.